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IOSR Journal of Business and Management (IOSR-JBM)
ISSN: 2278-487X. Volume 7, Issue 2 (Jan. - Feb. 2013), PP 83-88
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Impact of Tariff Structures on FDI in Pakistan
1
Arslan Pervez, 2Qaisar Ali Malik
1
2
FUIRC, Department of Business & Economics.
Assistant Professor, FUIRC, Department of Business & Economics.
Abstract: The purpose of present study is to construct a relationship between tariff structures and FDI to
identify and measure how and to what extent tariff structures of a country influences the FDI in today’s era of
increased capital mobility. On the basis of the review of literature the study took tariff structure as independent
variable to measure its effect on FDI being dependant variable. Gross capital formation, inflation and GDP are
taken as control variables affecting FDI in relation to changes in tariff structures. Time series secondary data
regarding the studied variables covering the period 1973 – 2011 is taken for conducting the analysis. Data
analysis for the present study is conducted through Augmented Dickey Fuller Test (ADF) for data stationarity;
Johansen Cointegration Test for data cointegration; and Least Square Regression Analysis for measuring the
impact of explanatory variables on dependant variable. The study concludes that lower tariff structures, higher
GDP and higher inflation increase the foreign direct investment whereas gross capital formation has no effect
on the foreign direct investment. The study recommends that tariff structures should be framed out in a way to
provide maximum tax incentives to foreign investors in order to promote FDI into the country. Moreover there
is a defiant need of stabilizing the political, social and economic systems as well along with the decreasing of
tariff structures to improve the FDI. The study is of crucial significance for a country like Pakistan; to attract
more FDI through framing out reasonable tariff structures; for the stability and growth of the economy of the
country.
Keywords: Tariff Structure, FDI, Gross Capital Formation, Inflation, GDP
I.
Introduction
Investment for a country is one of the most important components of income and growth and therefore,
by many policy makers, it is considered to be indispensible for the stability of the economy. Most of the
macroeconomic theories support that increase in savings and investments in an economy lead to the upward
growth curve of that economy. Foreign direct investment has been the most important inflow of income and
business that an economy attracts and then benefits from it. The literature however does not always supports the
relationship between economic growth of a country and foreign direct investment. The empirical studies from
the developed part of the world conclude that the relationship between foreign direct investment and economic
growth is contradictory and conflicting with no statistically significant relationships found (Vu & Noy, 2009).
Hence the policy makers attempt to manage the tax income of the economy through FDIs. The tariff structures
of the economy have a significant influence on the levels of FDI that a country attracts and thus it is important to
craft the right combination of tax structure amongst other factors to attract just the right amount of foreign
investment into the country. The present study intends to establish a relationship between foreign direct
investment and the tariff structures in Pakistan.
1.1 Significance of Study
The study is of crucial significance for a country like Pakistan; to attract more FDI through framing out
reasonable tariff structures; for the stability and growth of the economy of the country. However the study
presumes that the taxes imposed on FDI would be collected as per the tariff structures developed from time to
time.
1.2 Objective of Study
The basic research objective of the present study is to construct a generalizable relationship between
tariff structures and FDI to identify how tariff structures of a country influences the inflow of FDI, in the world
of increased capital mobility.
II.
Literature Review
Kim et al. (2012) stated that the impact of foreign direct investment on economy is still controversial in
the present literature as to whether the impact of foreign direct is positive or negative on the promotion of
economic growth. However Bekaert & Harvey (2000) pointed out that there is actually conventional wisdom
attached to the increase in foreign direct investment into the country. FDI inflow is important in promoting
economic growth because of two important reasons. Firstly, foreign direct investment enable to produce positive
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Impact of Tariff Structures on FDI in Pakistan
externalities for the organization in terms of disseminating advanced technological and managerial practices into
the country that is receiving foreign investment and secondly, by this inflow into the country, that is foreign
direct investment is more resistant to external global changes than other types of inflows into the country. Craig
and dollar (1996) observed that FDI accelerates the economic growth of the country and it’s contributing in the
development of human resource, capital formation, interlinked with global markets and advancement in
technology. Moreover they found that FDI and development indicators are linked positively. Mishkin (2009)
mentioned that foreign direct investment leads to technological advancement in the host country as well as
managerial advancement. This then overall contributes to making the structures of the host country stronger.
Varsakelis et al. (2010) stated that the significant reduction in the trade barriers during the last decade and the
resulting increase in the liberalization of capital flows have actually made foreign direct investment an
extremely important element for the economies. Azemar & Delios (2007) stated that the variations in FDI
against its various studied determinants depend significantly on the level of economic development in the host
country.
Girma (2005) revealed that positive absorption capacity of the host country allows the process of
positive spillovers of foreign direct investment to speed up, hence ensuring the better use of the foreign direct
investment for achieving economic growth. Absorption capacity is determined through a number of factors
including the new capital formulation; that is the conversion of savings into investment of a country; and the
economic stability. Thus the policy makers must offer some incentives to encourage new capital formulation
and economic stability in the country so as to increase the inflow of foreign direct investment. The economic
stability is being measured by the inflation rate and the new capital formulation is being measured by the index
itself. These two measures mutually denote the absorption capacity of the host country and the economic
stability of the country. Tyler (1981) studied middle east countries and found that the growth in the
manufactured exports in a country lead to the progress further leading to an increase in the absorptive capacity
for further investment. Hence an increase in the trade would lead to improvement in the economy if the
absorptive capacity of the country is able enough to do so in the long run (Krueger, 1978). Hansen & Rand
(2005) argued that FDI and gross capital formation are associated in the long run and that FDI has impact on
GDP through implementation of technology and transfer of awareness. Wang et al (2004) and Tsen (2006)
emphasized on the fact to better understand this relationship, one has to distinguish whether the situation is of a
growth led trade or a trade led growth because the phenomena significantly different in their dynamics.
Lim (2007) stated that restructuring of the tariff rates is actually one of the ways through which
countries seek to attract foreign direct investment into the country. In this regards there are a number of ways
through which FDIs can be attracted towards the country. In this context the economic determinants including
the policy structures and the level of business facilitation is of significant importance in aiding to increase
foreign direct investment in the country. Varsakelis et al. (2010) stated that there is little doubt about the fact
that the accelerated growth of the foreign direct investment in the recent past is a result of the tax differentials
that have been used by the policy makers to attract FDI all over the world. Haufler & Wooton (1998) compared
and analyzed the tax structures of two developing countries of different sizes and found that foreign direct
investment was more attracted towards the larger countries. The reason for such attraction was the autonomy of
prices to be charged by the investor though the tax structures in the larger country were comparatively higher.
Basically, smaller sized countries offering smaller tariff rates is basically like a compensation for their otherwise
unattractive markets (Raff and Srinivasan, 1997). Hines (2005) suggested that smaller and open economies
should comprehensively avoid the taxation of income earned on foreign investment so as to best incentivize the
flow of investment into the country. The study concluded that the return that the country earns through increased
foreign investment is much more than what it earns through taxing the investors’ income. Desai et al (2004)
noted that multinational organizations actually adjust their debt levels in accordance with the corporate tax rates
that they are faced with. Hence it endorses that the behavior of the multinational organizations is strongly
determined by what tax rates they are facing with. Desai et al. (2003) discussed that even though most of the
current literature on foreign direct investment focuses on corporate income taxes to analyze the attractiveness
and the level of FDI, non income taxes or the indirect taxation is also an important determinant of FDI in the
country because it burdens the operations of the organizations investing in a particular country. The literature
suggests though high corporate tax rates depress foreign direct investment whereas indirect taxes are not found
having strong significant relationship with FDI
Moreover it is also dependent on the phase of development that the country is in i.e. the equilibrium of
taxes and foreign investment would be on a different position in the United States of America than that in
Pakistan. The implication in this case is that the relationship between the two variables under consideration
requires significant probing to actually understand what the dynamics are. Azemar and Delios (2008) criticized
strongly that a great deal of the literature has been focused on finding the effect of tax rates on the foreign direct
investment in developed countries of the world, whereas the importance of studying this relationship lies in the
developing countries. Devereux and Griffith (1998) stated that there is a lack of empirical evidence regarding
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Impact of Tariff Structures on FDI in Pakistan
this issue for the developing countries because most often, there is a difficulty in calculating the appropriate tax
measures for developing countries. Moreover regarding literature available on foreign direct investment in
developing countries, it has to be noted that either researchers have significantly focused their studies on United
States of America or in OECD countries (Benassy-Quere et al., 2005) or have not distinguished between low
income and high income countries (Mutti & Grubert, 1991; Hines & Rice, 1994). Such studies have implicitly
assumed that the tax elasticities for foreign direct investment are identical for both the types of countries which
in reality is not the case as has been clearly pointed out by Blonigen and Wang (2005). Hence these systematic
differences between the high income and low income countries; as far as the tax elasticities are concerned;
imply that the data from the two sets cannot be pooled together for a study. Thus the developing countries have
to be studied separately (Mutti and Grubert, 2004).
The impact of tariff structure and FDI is rarely investigated in Pakistan. Trade policy of Pakistan has
been fluctuating; in 1950s protectionist policies were followed to save the infant industries; since 1960s imports
started and exports were given policy boosts through important substitution policies and devaluation of the
currency; in 1980s trade was liberalized Balassa (1971) by decreasing the tariff rate from 17 percent to 10
percent in 1987 (Hussain, 2003); the optimal tariff rate was limited to 25 percent which was further reduced to
14.7 percent (Kemal et al. 2002). Resultantly imports had grown significantly leaving the national production
and exports to be limited. UNCTAD (2005) showed that foreign direct investment is less in the favor of
developing countries (almost by 4.5 times) than in the favor of the developed countries. Apart from the tax
structures, the mediators are the weak economies and infrastructures, the political and social risks involved,
illiteracy and enforcement of property rights. Pakistan has followed market oriented policies for two decades
and getting higher amount of FDI inflow. In Pakistan significance of FDI inflow is highlighted in the form of
size and percentage of gross capital formation. Shah & Ahmad (2003) established that change in GDP and tariff
rate carry significant impact on FDI in long run. While tariff rate also support FDI in short run. Aqeel & Nishat
(2004) identified that FDI is attracted through government policies. The variables like corporate tax and custom
duties are significant. Awan & Zaman (2010) stated that FDI and inflation rate are significantly positive to
persuade foreign investors. Nonetheless, one thing that has been stated regarding foreign direct investment and
tax structure is that it leads to longer run benefits for the host countries. The openness in trade and capital
mobility allows the country to reap fruits in the future (Shahbaz, 2012).
III.
Methodology
3.1 Measurement of Variables
Craig and dollar (1996) observed that FDI accelerates the economic growth of the country and
contributes to the development of capital formation. Moreover FDI and development indicators are associated
positively. Azemar & Delios (2007) stated that the variations in FDI against its various studied determinants
depend significantly on the level of economic development in the host country. Girma (2005) revealed that
positive absorption capacity of the host country ensures the better use of the foreign direct investment for
achieving economic growth. Absorption capacity is determined through a number of factors including the new
capital formulation and the economic stability. The economic stability is being measured by the inflation rate
and the new capital formulation is being measured by the index itself. Hansen & Rand (2005) argued that FDI
and gross capital formation are associated in the long run and that FDI has impact on GDP through
implementation of technology and transfer of awareness. Lim (2007) stated that restructuring of the tariff rates is
actually one of the ways through which countries seek to attract foreign direct investment into the country. In
this context the economic determinants including the policy structures and the level of business facilitation is of
significant importance in aiding to increase foreign direct investment in the country. The present study addresses
the issue; as to what extent the variations in the tariff structures change the foreign direct investment with
respect to the development stage of Pakistan. On the basis of the review of literature the study took tariff
structure as independent variable to measure its effect on FDI as dependant variable. Gross capital formation,
inflation and GDP are taken as control variables affecting FDI in relation to changes in tariff structures.
3.2 Data Collection
Time series secondary data regarding the studied variables is used for conducting the analysis and
getting the results of the study. Time period of the study is 38 years starting from 1973 to 2011. The reason for
selecting the period is that it encompasses the long run variations in the studied variables. The data was
collected from online resources of World Bank, IFS and Ministry of Commerce, Pakistan.
3.3 Predicted Relationship
On the basis of review of literature and the findings of the earlier such studies, following relationship is
expected as shown in the hypothesis shown below:
H1: Higher tariff structure decreases the foreign direct investment.
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Impact of Tariff Structures on FDI in Pakistan
H2: Higher GDP increases the foreign direct investment.
H3: Higher inflation increases the foreign direct investment.
H4: Higher gross capital formation increases the foreign direct investment.
For the purpose of data analysis, the above stated relationships can be mathematically expressed as:
Ln (FDI) = β0 + Ln (GDP) + Ln (INF) + Ln (CAP) + Ln (DTR) + error
Where;
FDI = Foreign Direct Investment in Pakistan
GDP = Real Gross Domestic Product
CAP = Gross Capital Formation
DTR = Change in Tariff Rate
INF = Inflation Rate
3.4 Data Analysis
Data analysis for the present study is conducted through Augmented Dickey Fuller Test (ADF) for data
stationarity; Johansen Cointegration Test for long term association of variables; and Regression Analysis for
measuring the impact of explanatory variables on dependant variable.
IV.
Analysis & Discussion
Augmented Dickey Fuller Test (ADF) is used to test the data stationarity. The results in table 4.1 below
indicate that all the selected variables including FDI, GDP, INF, CAP and DTR are stationary at first difference
with intercept, trend and none.
FDI
GDP
INF
CAP
DTR
Table 4.1
Unit Root Test: ADF
Unit Root Conducted at first difference
Intercept
Trend
NONE
-9.04
-8.9599
-8.338
-7.850
-7.822
-3.723
-5.36
-5.371
-5.47
-6.087
-6.271
-4.05
-6.777
-6.864
-6.9064
After testing for data stationarity data co integration is tested through Akaike Information Criteria (AIC). AIC
are lowest at assumption of “no intercept and no trend” represented by “Assumption 1” as in table 4.2 below.
This assumption is taken to execute co-integration test.
0
1
2
3
4
5
Assumption 1
-2.154341
-3.181850
-3.537974
-3.430834
-3.181969
-2.669376
Table 4.2
Co-integration Assumptions Summary
Akaike Information Criteria by Model and Rank
Assumption 2
Assumption 3
Assumption 4
-2.154841
-3.081116
-3.081116
-3.299749
-3.887583
-4.072431
-3.637652
-3.997227
-4.128632
-3.690441
-4.002491
-4.131353
-3.527465
-3.710678
-3.885414
-3.160965
-3.160965
-3.523199
Assumption 5
-2.958554
-3.984435
-4.064716
-4.054769
-3.861964
-3.523199
Cointegration test result discloses that Eigen values are greater than critical values therefore livelihood ratio
indicates four cointegration equation at 5% significant level. The trend assumes that there exists no trend in the
given time series. The assumption used in the table 4.3 below is “no trend and no intercept”.
Table 4.3
Co-integration test
Sample: 1 38
Included observations: 36
Test assumption: No deterministic trend in the data
Series: FDI GDP INF CAP DTR
Lags interval: 1 to 1
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Impact of Tariff Structures on FDI in Pakistan
Likelihood
5 Percent
1 Percent
Hypothesized
Eigenvalue
Ratio
Critical Value
Critical Value
No. of CE(s)
0.794655
118.5413
59.64
65.25
None **
0.598151
61.55093
38.98
44.85
At most 1 **
0.361361
28.73048
23.41
28.95
At most 2 *
0.264122
13.85752
13.35
15.81
At most 3 *
0.042053
1.546668
4.48
7.65
At most 4
*(**) denotes rejection of the hypothesis at 5%(1%) significance level
L.R. test indicates 4 cointegrating equation(s) at 5% significance level
Least square regression results in table 4.4 below indicate that GDP, INF and DTR are significant predictors of
FDI whereas CAP is insignificant predictor of FDI. The three variables; GDP, INF and CAP are positively
associated to FDI whereas DTR is negatively associated to FDI. Adjusted R2 depicted that almost 89 percent of
the variability in the foreign direct investment in the country is due to the changes in the explanatory variables.
Probability of F statistics indicates the fitness of overall model. The results supported the acceptance of H1 higher tariff structure decreases the foreign direct investment; H2 - higher GDP increases the foreign direct
investment; and H3 - higher inflation increases the foreign direct investment. H4 - higher gross capital formation
increases the foreign direct investment; is rejected being insignificant predictor though the observed relationship
is positive as predicted.
Table 4.4
Least Square Estimation
Sample(adjusted): 2 39
Included observations: 38 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
GDP
0.901444
0.237764
3.791335
INF
0.714773
0.218422
3.272449
CAP
0.412224
0.404538
1.019001
DTR
-1.220749
0.605113
-2.017390
C
5.454406
7.682404
0.709987
R-squared
0.897596
Mean dependent var
Adjusted R-squared
0.885183
S.D. dependent var
S.E. of regression
0.598106
Akaike info criterion
Sum squared resid
11.80511
Schwarz criterion
Log likelihood
-31.70765
F-statistic
Durbin-Watson stat
1.689204
Prob(F-statistic)
V.
Prob.
0.0006
0.0025
0.3156
0.0518
0.4827
19.17615
1.765124
1.931981
2.147453
72.31307
0.000000
Conclusion
The above analysis and discussion concludes that lower tariff structures, higher GDP and higher
inflation increase the foreign direct investment whereas gross capital formation has no effect on the foreign
direct investment. Hence tariff structures should be framed out in a way to provide maximum tax incentives to
foreign investors in order to promote FDI into the country. Though Pakistan presently needs huge sum of money
to handle the present crisis and support the economy; and these funds may be generated, for the time being,
through imposing high direct and indirect taxes on foreign investments; but the higher tariff structures would
discourage the foreign investment as is obvious from the findings of the study. Moreover the funds generated
through higher tariffs may be highly insignificant as against the overall economic benefits that could come into
the stream due to the increased FDI over the long run. A careful investigation and analysis is required as to what
extent the tariff structures may be increased without adversely affecting the FDI. In case of Pakistan despite of
decreasing tariff structures FDI is continuously decreasing because of the present bundles of crisis Pakistan is
facing. A cost benefit analysis needs to be conducted to evaluate the benefits of tax incentives to be granted as
against the cost of political, social and economic instability the country is facing. Hence there is a defiant need
of stabilizing the political, social and economic systems as well along with the decreasing of tariff structures to
improve the FDI.
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Impact of Tariff Structures on FDI in Pakistan
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